Many project managers may not calculate budgets and return on investments for every project. In matrix organizations, where most project teams consist of functional employees, financial metrics aren’t often needed or required.
If that’s the case for you, this refresher should get you thinking about the financial side of projects again.
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Project budgets and estimates should be presented in range. For example, project ABC will cost $900,000 to $1,250,000. The range will change over time as more information becomes clear and risk decreases.
At the beginning of a project, it’s best to use a rough order of magnitude when determining a project’s cost. When there is a lot of uncertainty and risk, and the project manager should not commit to a narrow estimate. The rough order of magnitude is general +75% to -25% of actual costs. So if an initial, rough projection of project costs is about $2M, the rough order estimate would be $3.5M (+75%) to $1.5M (-25%).
Once a project manager has a well-defined scope,schedule, and an understanding of project risk, a budget can be determined. The project budget is usually about +25% and -10%. Therefore if the best estimate is $2M, the project budget should be $2.5M to $1.8M.
As a project progresses, risk and uncertainty decrease. Therefore estimate ranges should decrease as well. A common range to use at this stage is +/- 10%. Using the same $2M from before, if your project is 25% done, an updated project estimate would be $2.2M to $1.8M.
Return on Investment
The return on investment is the percentage that an investment is expected to earn. The calculation is:
ROI = (Benefit – Cost) / Cost
ROIs are great ways to determine if a project should be initiated. An organization can also compare the ROIs of two different projects to decide which one to pursue.
Calculating the ROI for a project can be difficult when working with ranges. As an example, project XYZ will generate $4-6M of income over the next ten years and will cost $3.5-1.5M to complete in just 1 year.
In this example, not only is there a cost range, but there is a benefit range as well. For simplicity sake, we’ll ignore time value of money for now.
In order to calculate the ROI range for this project, you should take the worst case and best scenarios. In the worst case, the project will cost $3.5M and earn $4M. In the best case, the project will cost $1.5M and earn $6M.
ROI = (4 – 3.5) / 3.5 = 14%
ROI = (6 – 1.5) / 1.5 = 300%
So the total ROI for this project ranges from 14% to 300%.
Time Value of Money
The above example ignores time value of money (TVM).
TVM is a way to discount money earned in the future back to the value of money today. An easy way to think about this is with a savings account. If $100 was put into a savings account with a 6% interest rate, in one year the savings account would have about $106 in it. The extra $6 is the interest earned on the account over the year. Now if you reverse this, $106 earned a year from now is only worth $100 today. That’s the principle behind TVM.
In our previous example, the project would earn either $4M or $6M over a ten year period. The money earned in the future that is not worth as much as money earned today. Without getting too technical, a project manager needs to discount these earnings in order to calculate the amount that they are worth in today’s dollars (the net present value).
Let’s see we did that calculation and the net present value of the $4M was $3M, and the $6M was $5M. This changes the ROI range quite a bit.
Now our worst case is -14% and our best case is about 230%. While this project can still provide a great return, there is also a possibility that it will lose money making a risky endeavor.
It’s important to note that this concept should also be applied to projects that take multiple years to complete. If costs are spread over more than a year, the project manager should calculate the net present value of costs as well when determining ROI.
Not all projects require financial projections, but a large number do. Therefore project managers should be familiar with these concepts. Projects with a lower ROI will naturally hold more risk and be subject to a more stringent budget.